Securities Regulation & Law Report™ Reproduced with permission from Securities Regulation & Law Report, 46 SRLR 875, 05/05/2014. Copyright ஽ 2014 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com ANTIFRAUD Corporate Scienter Under Section 10(b) and Rule 10b-5 DANIEL A. MCLAUGHLIN AND MARK TATICCHI explicit rationale for their treatment of corporate scien- ter. Even today, courts continue to describe this as an open issue even in Circuits where it has been settled in I. Introduction practice for some time—a reticence that deprives liti- gants and District Courts of needed guidance. orporations are named as defendants in nearly ev- Despite the lack of consensus on how to describe the ery federal securities fraud case under 1934 Secu- rule or even on which courts have adopted it, however, C rities Exchange Act (‘‘1934 Act’’) Section 10(b) a review of Section 10(b) cases reveals that, in practice, and Rule 10b-5. The most frequently litigated issue in the courts have adopted a de facto rule grounded in tra- Section 10(b) cases, especially at the pleading stage, is ditional principles of agency law as set forth in the Re- scienter, i.e., whether the plaintiff has pleaded facts statement of Agency: a corporation can violate Section raising a ‘‘strong inference’’ that the defendant—often, 10(b) only when at least one of its employees or authorized a corporate defendant—has acted with the required ‘‘in- agents knowingly or recklessly violates Section 10(b) in the tent to deceive, manipulate, or defraud.’’ Yet, despite scope of his or her employment. The Restatement rule de- the importance of this question, the federal securities rives from the fact that the Section 10(b) private cause laws are mostly silent on how to ascertain the intent of of action is an intentional tort, and an intentional tort a corporation or other business entity, and the courts, can be committed only when the person committing the until relatively recently, have been hesitant to offer an tort has the required intent. There is no basis in the stat- ute or the case law for a rule of ‘‘collective scienter’’ un- der which one corporate agent’s conduct can be mixed- Dan McLaughlin is counsel in the securities and-matched with another corporate agent’s state of litigation practice of Sidley Austin LLP in the mind to fabricate a corporate violation that was com- firm’s New York office. His e-mail address is mitted by no natural person. Such an approach has [email protected]. Mark Taticchi is an rightly been rejected, either expressly or by implication, associate in Sidley Austin LLP’s New York by nearly every federal Circuit to confront the issue. office. His e-mail address is mtaticchi@ sidley.com. The Restatement rule is consistent with the federal courts’ treatment of corporate litigants in this and other The views expressed in this article are exclu- areas of law, and with background principles of agency sively those of the authors and do not nec- law against which Congress is presumed to legislate. essarily reflect those of Sidley Austin LLP and Only a minority of courts have adopted different rules its partners. for corporate knowledge under federal law, and have done so in different statutory contexts based on consid- COPYRIGHT ஽ 2014 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN 0037-0665 2 erations that are not properly extended to an implied As the Court elaborated in subsequent cases, mere cause of action for intentional tort. corporate mismanagement or misconduct does not vio- late Section 10(b) unless the actions at issue are fraudu- Applying the Restatement rule to Section 10(b) lent in nature: ‘‘Section 10(b) is aptly described as a claims has a number of significant ramifications in catchall provision, but what it catches must be fraud.’’6 practice. For example, at the pleading stage, the statu- Moreover, the intended deceit must be ‘‘use[d] or tory requirement of pleading particular facts that raise employ[ed] in connection with the purchase or sale of a ‘‘strong inference’’ of scienter suggests that courts [a] security,’’7 and thus specific intent is required: not should—in most or all cases—require that the com- merely to commit some general bad act, but rather ‘‘in- plaint identify one or more relevant corporate officers tentional or willful conduct designed to deceive or de- and connect the allegations of knowledge to those offi- fraud investors by controlling or artificially affecting cers. At the discovery stage, identification of the indi- the price of securities.’’8 viduals who are alleged to have committed the tort can In setting the pleading standards for scienter in the help significantly focus discovery and avoid massive Private Securities Litigation Reform Act of 1995 dragnets of the e-mails of all corporate employees who (‘‘PSLRA’’), Congress made explicit that the required might possibly have knowledge that could be aggre- state of mind must be connected to the act of deception: gated. And at settlement, releases of the wrongdoing in- dividuals will extinguish the liability of the corporation. [I]n any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the II. Overview: Scienter, The Statute and The complaint shall, with respect to each act or omission al- Common Law leged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted 9 A. Scienter Under Section 10(b) and Rule 10b–5. Sec- with the required state of mind. tion 10(b) of the 1934 Act– along with Rule 10b-5, pro- The statute, however, speaks only once about the in- mulgated under its authority—is a civil regulatory and tent of a corporation. The statutory safe harbor for criminal prohibition, from which the courts have im- forward-looking statements, contained both in Section plied a private right of action. Section 10(b) makes it 27A of the Securities Act of 1933 (‘‘1933 Act’’) and Sec- unlawful ‘‘[t]o use or employ, in connection with the tion 21E of the 1934 Act, allows a defendant to evade purchase or sale of any security . any manipulative or responsibility for certain forward-looking statements. 1 deceptive device or contrivance.’’ As the U.S. Supreme The safe harbor is expressly made available to both the Court held in Ernst & Ernst v. Hochfelder, by using the corporate issuer and ‘‘[a] person acting on behalf of terms ‘‘ ‘manipulative,’ ‘device,’ and ‘contrivance,’ ’’ such issuer,’’ as well as an underwriter and an ‘‘outside Congress deployed ‘‘the commonly understood termi- reviewer retained by such issuer,’’ such as an auditor, nology of intentional wrongdoing’’—statutory language and liability may be imposed only if the statement that makes ‘‘unmistakable a congressional intent to proscribe a type of conduct quite different from negli- (i) if made by a natural person, was made with ac- gence.’’2 Thus, the Court in Ernst rejected the tual knowledge by that person that the statement was ‘‘common-law and statutory duty of inquiry’’ the lower false or misleading; or courts had imposed on an accounting firm and held in- (ii) if made by a business entity; [1] was— stead that liability under Section 10(b) requires proof of scienter: ‘‘a mental state embracing intent to deceive, (I) made by or with the approval of an execu- manipulate, or defraud.’’3 The Court later made explicit tive officer of that entity; and that the same element of ‘‘ ‘knowing or intentional mis- (II) made or approved by such officer with ac- conduct’ ’’ applies in SEC enforcement actions, because tual knowledge by that officer that the statement 10 it is drawn from the language of the statute.4 While ev- was false or misleading. ery Circuit to consider the question has held that scien- ter can be shown by reckless conduct, the various defi- cient to establish Section 10(b) liability. See Tellabs, 551 U.S. nitions of recklessness adopted by different Circuits at 319 n. 3; Ernst, 425 U.S. at 193 n. 12. have steered close to Ernst’s description of recklessness 6 See Chiarella v. United States, 445 U.S. 222, 230, 234-35 as ‘‘a form of intentional conduct’’ akin to willful blind- (1980); Santa Fe Indus. v. Green, 430 U.S. 462, 479 (1977). ness, and have resisted any definition that would re- 7 15 U.S.C. § 78j(b). semble the negligence liability rejected in Ernst.5 8 Ernst & Ernst, 425 U.S. at 199 & nn. 20-21. See Cozzarelli v. Inspire Pharmaceutical, 549 F.3d 618, 628 (4th Cir. 2008) (not fraudulent for corporation to keep information in confi- 1 15 U.S.C. § 78j(b). dence with the ‘‘lawful intent’’ of furthering its ‘‘competitive 2 Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199, 214 (1976) interests.’’); Kalnit v. Eichler, 264 F.3d 131, 141 (2d Cir. 2001) (emphasis added). (concealing information from proposed merger partner ‘‘can- 3 Id., at 192, 193 n.12. not be conflated with an intent to defraud the shareholders’’). 4 Aaron v. SEC, 446 U.S. 680, 689-95 (1980) (quoting Ernst, Moreover, a defendant must know ‘‘that not disclosing [a fact] 425 U.S. at 197). posed substantial likelihood of misleading a reasonable inves- 5 See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. tor,’’ which requires the defendant to know what disclosures 308, 319 n. 3 (2007) (citing Ottmann v. Hanger Orthopedic were being made. City of Philadelphia v. Fleming Cos., 264 Grp., Inc., 353 F.3d 338, 345 (4th Cir.